You Don’t Need to Know What a Stock’s Worth to Know It’s Cheap

by Geoff Gannon

Someone emailed me asking what sources they needed to study to get better at valuing stocks.

My answer was that the ability to come up with accurate valuations for public companies is overrated.

Why? Because…

It's rarely important to know how to value a company. What's important is the ability to recognize when a company is clearly selling for less than it's worth and then acting on that knowledge.

For example, in a write-up I did on my member site (Focused Compounding) explaining why I put 50% of my portfolio into NACCO (NC) when it completed the spin-off of Hamilton Beach (HBB), I said that:

"I think of each share of NACCO as an inflation adjusted stream of free cash flow. As I’ve shown, I think the stream has a ‘coupon’ of greater than $3.25 and I bought it at $32.50. So, the yield is 10% or more and that’s effectively a ‘real’ yield.

The average U.S. stock has a free cash flow yield in the 4% to 5% range and that yield is not as well protected against inflation.

It’s true that NACCO’s yield will eventually decline as coal power plants shut down (although, in recent years, the tons of coal supplied has risen rather than fallen). However, I think of my ‘margin of safety’ as being the fact that it isn’t 100% certain these plants will shut down and they haven’t shut down yet. Till they do, cash will build up on the balance sheet of NACCO (the parent company) or it will pay out dividends, buy back stock, or acquire businesses unrelated to coal mining (as it did in the past)."

It's important to note that:

1) I never said that NACCO's cash earning power is $3.25 a share. I said it's at least $3.25.

2) I never said that the right multiple for NACCO is 10 times FCF. I just said that a normal stock trades for 20-25 times FCF (a 4% to 5% FCF yield) and NACCO trades for no more than 10 times FCF.

In fact, in that same article, I walk through ways of estimating what cash earnings would be in a normal year for NACCO (now that's it just the coal business). The range of earnings estimates these different methods give you actually cluster around $4.75 to $5.50 a share (not the $3.25 figure I cite). However, I didn't think those numbers were important when the stock was at $32.50.

Why? Because…

Earnings of $4.75 to $5.50 on a $32.50 stock are overkill. You don't need to know if a stock has a P/E of 6 to 7. What you need to know is how certain it is that a stock doesn't have a P/E any higher than 10 to 11.

So, I spent more time focusing on the fact that the method of estimating earnings that was most conservative - using this year's tons of production and multiplying it by the lowest ever profit per ton the company achieved in the last 25 years - still gives you about $3 a share in cash earnings. The thing I thought was a lot more important than correctly valuing the stock was proving that the stock was almost certainly priced at 11 times cash earnings or less when I bought it. If the average stock trades for at least 20 times cash earnings and I am buying something at no more than 11 times cash earnings, I'm getting a 45% discount.

When buying a stock: the important thing isn't whether you’re getting a 45% discount or a 75% discount. It's establishing how certain you are that you really are getting a 45% discount. 

The relevant Ben Graham quote here is:

"You don't have to know a man's exact weight to know that he's fat."

It's not that important to know the exact value of anything in the stock market. What's important is knowing there's a big gap between some value you think it's highly probable a stock's worth more than and the value you're paying.

So, say the average stock trades for 25 times its after-tax free cash flow (when it's unleveraged). And then you find a stock that you think is equal to or better than the average public company in terms of quality, durability, safety, etc. Fine. What you do then is you say: well if the average stock is worth 25 times cash earnings right now and I think this stock is probably a bit better than the average stock - then I can be very sure it's worth at least 15 times earnings. So, you build a 40% discount right into your initial assumptions about the stock.

And then, what you try to do is force yourself to wait till the stock is trading not at 15 times earnings (where you feel certain it's not expensive) but at more like 10 times earnings (where you know it's cheap). You take your initial conservative assumption that forms your belief about the stock and then you insist on an extra margin of safety before you turn that belief into action.

So, now you've taken your initial 40% discount in terms of how conservative you were in valuing the company. And then you've built an extra 35% discount of inaction into your investment. 

Honestly, that's how you'll make money in the stock market. It's not by knowing exactly what anything's most likely worth that matters. It's knowing what something is almost certainly worth more than that matters. 

In value investing: technique isn't very important. Discipline is.

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